HARAMBEE UNIVERSITY

FACULTY OF BUSINESS AND ECONOMIS

ACCOUNTING AND FINANCE DEPARTMENT
FINANCIAL MANAGEMENT II
CHAPTER TWO
A REVIEW OF DIVEDEND AND DIVIDEND POLICY

2.1 DIVIDEND THEORIES

The major decisions of financial management of any business are investment, financing, and
dividend decisions. The dividend decision is also an integral part of financing decision. When a
company earns profits, it must decide as to how much of the profit should be distributed by way
of dividend to the shareholders and how much to be retained for future purpose.

These retained earnings are the internal sources of finance to the company. Thus, the earnings
available to shareholders are equal to the dividends plus retained earnings. The success of any
business firm rests not only on the optimal utilization of funds but also on efficient management
of income earned from its business operations. The distribution of fair amount of dividend to
shareholders, provision for sufficient reserves to finance future opportunities and to absorb the
shocks of business and provision of adequate resources for retiring old bonds and redeeming
other debts call for effective management of income. The efficient management of income
strengthens the financial position of the business enterprise and enables the firm to withstand
seasonal fluctuations and oscillations. It also helps in enlisting the support of the shareholders in
future and finally facilitates in raising funds from different avenues of capital market.

As such the dividend decision is one of the most important areas of decision making for a
finance manager. Now, the issue is how significant is the Dividend Decisions? Does it affect the
value of the firm? Does it affect the cost of capital of the company? If the answer to these two
questions is `yes’ dividend decision is significant.

On the question of influence of dividend decision on the value of the firm and cost of capital
there are contradicting views. One view states that the dividend decision does not influence the
value of a firm, which means the dividends are irrelevant.

Another school of thought is that the dividends are relevant, which means the value of a firm
depends on the dividend decision. Therefore, theories of dividend can broadly be classified into
two groups:

1) Which consider divided policy as a relevant variable to enhance shareholder’s wealth, and

2) Theories which consider divided policy as of no relevance.

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2.1.1 RELEVANCE THEORIES OF DIVIDEND

The relevance dividend theories support the view that the dividend policy has profound impact
on the value of a firm. There are two theories under this school of thought. They are:

1) Walter’s Model

2) Gordon’s Model

2.1.1.1 Walter’s Model

Walter's model suggests that there is positive relationship between dividend policy and value of
the firm. According to this model, the rate of return, i.e., 'r', and cost of capital i.e., 'k' plays a
significant role in achieving ultimate goal of wealth maximization of shareholders.

The model is based on the following assumptions:

The Company is an all – equity financed entity.
It depends on retained earnings only to finance future investment projects.
Return on investment is constant
The Company has perpetual life
𝑟
𝐷𝑃𝑆 (𝐸𝑃𝑆−𝐷𝑃𝑆)( )
𝑘
Model: 𝑀𝑃𝑆 = [ + ]
𝑘 𝑘
Where
P = Market price of an equity share (MPS)
D = Dividend per share (DPS)
E = Earnings per share (EPS)
r = Rate of return on investment
k = Cost of capital
(E - D) = Retained earnings
(E – D) r = Return on retained earnings invested.
This model leads us to three situations:
When return on investment (r) is greater than cost of capital (k) (r>k) [growth company]
When return on investment (r) is less than cost of capital (k) [r<k) [declining company]
When return on investment (r) is equal to cost of capital (k) [r=k] [normal company

Illustration: 2
From the following information calculate the market value of equity shares of a company
Using Walter’s model.

Earnings per share = br.5; Dividend per share = br.3

Return on investment = 10%; Cost of Capital = 10%

Will there be any change in the market value of equity share if the dividend payout ratio is100%
in the place of present rate of 60%?
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Answer: Using Walter’s model the market value of the share is calculated as:
𝑟
𝑑𝑝𝑠 (𝑒𝑝𝑠 − 𝑑𝑝𝑠) (𝑘)
𝑚𝑝𝑠 = [ + ]
𝑘 𝑘
0.1
3 (5 − 3) ( )
𝑚𝑝𝑠 = [ + 0.1 ]
0.1 0.1
3+2
𝑚𝑝𝑠 =
0.1
𝑚𝑝𝑠 = 𝑏𝑟. 50

If the dividend payout ratio is 100% in the place of present rate of 60% dividends per share
(D) Will be Rs.5. The market value of the share will be
0.1
5 (5−5)( )
0.1
𝑚𝑝𝑠 = [0.1 + ]= br. 50
0.1
There is no change in the market value because return on investment (r) is equal to cost of
Capital (k). This is a case of normal company, dividend payout ratio has no bearing on the value
Of the share. That is why dividend policy is irrelevant in such cases.
Questions
1. From the following information, calculate the market value of equity share of a company
using Walter’s model.
EPS = br.5; DPS = br.3; r = 15%; k = 10%
Will there be any change in the value, if 100% dividends are paid instead of present 60%?
2. From the following information find out the market value of equity share of a company
Using Walter’s model.
EPS = br.5; DPS=br.3; if r= 7.5%; k = 10%
Will there be any change in the value if the dividend payout ratio is 100% (that is, if DPS =
br.5)

2.1.1.2 Gordon Model

Gordon’s theory on dividend policy is one of the theories believing in the ‘relevance of
dividends’ concept. It is also called as ‘Bird-in-the-hand’ theory that states that the current
dividends are important in determining the value of the firm. Gordon’s model is one of the most
popular mathematical models to calculate the market value of the company using its dividend
policy.

The Gordon growth model formula is based on the mathematical properties of an infinite series
of numbers growing at a constant rate. The three key inputs in the model are dividends per share
(DPS), the growth rate in dividends per share, and the required rate of return (ROR).

𝐷1
𝑃=
𝑟−𝑔

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Where:
P=Current stock price
g=Constant growth rate expected for dividends, in perpetuity
r=Constant cost of equity capital for the company (or rate of return)
D1=Value of next year’s dividends

Or the GGM formula can also be written as

𝑒𝑝𝑠(1 − 𝑏)
𝑃=
𝐾𝑒 − 𝑏𝑟
Where;
P= current price of a share
Eps= earnings per share
b= retention ratio
1-b=D/P ratio
The Gorden model is similar to Walter's model.
✓ When the rate of return (r) is greater than cost of capital (k), the value of a share increases
as the dividend payout ratio decreases. Therefore, optimum dividend payout ratio is 0%.
✓ When the rate/of return is equal to cost of capital (r=k], the value of a share remains
unchanged in response to changes in dividend payout ratio. Therefore. Dividend policy is
irrelevant.
✓ When the rate of return is less than cost of capital (r<k), the value of a share increases as
the dividend payout ratio increases. Therefore, 100% dividend payout ratio is optimum.

If the growth rate is a mix of constant ant inconstant, two-stage model and stable model will be
applied to compute the current value a stock on such a way
𝑑1 𝑑2 𝑑3 𝑑𝑛 + 𝑃𝑛
𝑝0 = ( + + + ⋯+ )
1 + 𝐾 (1 + 𝑘)2 (1 + 𝑘)3 (1 + 𝑘)𝑛

Pn= dn+1/(k-g)
dn=dn-1(1+g) or dn=d0(1+g)n

Illustration: 3
The following information is collected from the annual reports of x co.
Profit before tax……………………….. Br. 2,500,000
Tax rate…………………………………….40%
Retention ratio…………………………..…40%
# of outstanding shares……………………. 500,000
Equity capitalization rate…………………. 12%
Rate of return on investment……………….15%

What should be the market price per share according to Gorden’s model of dividend policy?
Solution:

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 [(𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥) ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)]
𝑒𝑝𝑠 =
𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠
2.5 ∗ 0.6
=
0.5
= 𝑏𝑟. 3
3(1 − 0.4)
𝑚𝑝𝑠 =
0.12 − (0.4 ∗ 0.15)
1.8
𝑚𝑝𝑠 = 0.12 − 0.06
1.8
𝑚𝑝𝑠 = 0.06
𝑚𝑝𝑠 = 𝑏𝑟. 30

Q3. From the following information relating to a co., determine the market price of a share using
goeden’s model.
Total investment in assets…………………………………….br. 1,000,000
# of shares …………………………………………………………. 50,000
Total earnings………………………………………………………..200,000
Cost of capital………………………………………………………… 16%
Payout ratio……………………………………………………………..40%

Q4. The EPS of the company is br. 15. The market rate of discount applicable to the company is
12%. The dividends are expected to grow at 10% annually. The company retains 70% of its
earnings. Calculate the market value of the share using the Gordon’s model.

2.1.2 IRRELEVANCE THEORIES OF DIVIDENDS

2.1.2.1 Traditional Theory

The traditional theory of dividend policy suggests that a firm should pay just enough dividends
to attract investors who prefer dividends over capital gains. According to this theory, dividend
policy does not impact the value of a firm. Therefore, firms which pay more current dividends
will have higher market value than the firms which pay less dividends.

The model is expressed in the following way

𝐸𝑃𝑆
MPS = M [DPS + 3 ]
Where
P = Market price per share
D = Dividend per share
E = Earnings per share
M = Multiplier
In the above model earnings per share (E) is equal to the sum of dividend per share
(D) And retained earnings per share (R)
EPS = DPS + RES
Substitute this expression in above equation to get

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 4𝐷𝑃𝑆 𝑅𝑃𝑆
𝑀𝑃𝑆 = 𝑀 [ + ]
3 3

Illustration: 1
From the following information calculate the market value of equity shares of a company
And its retained earnings per share using traditional theory
M=10, DPS= br. 0.77, EPS= br. 10

Answer;
𝐸𝑃𝑆
𝑀𝑃𝑆 = 𝑀 [𝐷𝑃𝑆 + ]
3
10
𝑀𝑃𝑆 = 10[0.77 + ]
3
𝑀𝑃𝑆 = 10[0.77 + 3.33]
𝑀𝑃𝑆 = 𝑏𝑟. 41

REPS= EPS-DPS
= 10-0.77
=br. 9.23

2.1.2.2 MM model

Merton Miller and Franco Modigliani have supported the view that the value of a company is
determined by its basic earning power and its risk class. According to them, the value of a
company depends on asset investment policy, but not on how the company's earnings are split
between dividends and retained earnings.

The model is based on the following assumptions.

* Capital market is perfect

* Investors are rational \
* Information is freely available
* Transaction costs are nil
* Securities are divisible
* No investo1:.can influence the capital market
* There are no floatation costs
* There-are no' corporate taxes

Company's investment policy is independent of its dividend policy.

Investment opportunities and future profits of companies are known with certainty.
**
Model:

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If we take one year period of holding, the value of share P0 will be equal to present value of
dividend paid at the end of one year (D1) plus present value of share price at the end of one year
(P1)

𝐷1+𝑃1
𝑃0 = 1+𝐾 …………………………..1
Total stock value will be equal to P0 multiplied by number of shares
𝑁.𝐷1+𝑁.𝑃1
𝑁𝑃0 = 1+𝐾 ………………………2

If the company sells 'M' number of shares at price 'p)' at the end of one year, it brings MP, of Birr
of capital. These new shares will not receive any dividend.
We can add MP, and subtract MP, to the numerator of equation 2, the value will not change
𝑁𝐷1+𝑁𝑃1+𝑀𝑃1−𝑀𝑃1
𝑁𝑃0 = ……….3
1+𝐾

𝑁𝐷1+(𝑁+𝑀)𝑃1−𝑀𝑃1
𝑁𝑃0 = ………4
1+𝐾
Current value of stock is equal to the present value of dividends plus the stock value at the end of
one year minus the value of new stock belonging to the new shareholders.
If we assume that the company's net income during the year is 'X' and its total new investment
during the year is "I" and it does not use debt, the sources and uses of funds at the end of one
year will be as follows

Sources of funds " Uses of funds

New share capital (MP1) New Investment (I)
Net Income (X) Dividends (NDI)

Sources' of funds are equal to uses of funds.

Sources of funds = uses of funds
𝑀𝑃1 + 𝑋 = 𝐼 + 𝑁𝐷1………5

𝑀𝑃1 = 𝐼 + 𝑁𝐷1 − 𝑋………6

Now, substitute equation 6 into equation 4
𝑁𝐷1+(𝑁+𝑀)𝑃1−(𝐼+𝑁𝐷1−𝑋)
𝑁𝑃0 = …….7
1+𝐾
𝑁𝐷1+(𝑁+𝑀)𝑃1−𝐼−𝑁𝐷1+𝑋
𝑁𝑃0 = ….…..8
1+𝐾
(𝑁+𝑀)𝑃1−𝐼+𝑋
𝑁𝑃0 = …………..……9
1+𝐾

Equation 9 presents MM's basic expression of current value of a company. From the equation we
can understand that value of a company is dependent upon its net income, the investment, the
amount of capital and cost of capital but the value is not influenced by the dividends.
MM argue that any gain in stock value resulting from an increase in dividends is exactly offset
by a decrease in the stock value as a result of fall in the stock end of period value (PI)' MM
believe that the shareholders received income either by way of dividends (DI) or capital gain
which is the difference between current price (P) and price at the end of the period (PI)'

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According to them the shareholders are indifferent between current dividend or capital gain,
Therefore. Dividend policy is irrelevant.

Illustration: A chemical company currently has 100,000 equity shares selling at Br. 100 each.
The' "company expects to earn a net income of Br. 1,000,000 during the current year and it has a
proposal for a new investment of Br.2,000,000, the company's cost of capital (k) is 10%.
Illustrate with the help of MM model that value of stock remained unaffected by dividend policy
by considering the following two cases which are
1. When dividends of Br. 6 per share are declared.
2. When dividends are not declared

Solutions
We know that current value of stock is Po; the present value of dividends at the end or one year
(DI) and price of stock at the end of one year (PI)

Situation 1 - When dividends of br. 6 per share are declared.

𝐷1 + 𝑃1
𝑃0 =
(1 + 𝑘)

From this equation we can solve Pi as follows.

𝑃1 = 𝑃0(1 + 𝐾) − 𝐷1

I NP0 == old capital = 100,000 shares x br. 100 = br. 10,000,000

X = Net income = br. 1,000,000
I = New Investment= br. 2,000,000
NDI = Dividend = (br, 6) x 100000 shares = br. 600,000
MPI = New capital required = br. 1,600,000 (2,000,000+600,000-1,000,000)
From equation (2) we can find PI
PI = Po (l+K) - DI = 100 (1+10%) - 6 = br. 104

𝑛𝑒𝑤 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐼 + 𝑁𝐷1 − 𝑋

#𝑜𝑓 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠 = =
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠 𝑃1
(2,000,000 + 600,000 − 1,000,000)
=
104
200000
=
13
(𝑁+𝑀)𝑃1−𝐼+𝑋
Value of Stock = 1+𝐾
(100,000+200000/13)∗104−2,000,000+1,000,000
=
1.1
=𝐵𝑟.10,000,000

Solution 2: When dividends are not declared

N == 100,000 shares, X = br. 1,000,000 I == br. 2,000,000

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k = 10% DI =0
PI = Po (1+k) - DI = 100 (1+10%) - 0 = br. 110

𝐼+𝐷−𝑋
Number of New shares (M)= 𝑃1
2,000,000+600,000−1,000,000
=
110
200,000
= 11

(𝑁+𝑀)𝑃1−𝐼+𝑋
Value of Stock= 1+𝐾
200,000
[(100,000+ )∗110−2,000,000+1,000,000]
= 11
1.1
=𝑏𝑟.10,000,000

2.2 Establishing of dividend policy in practice

When it comes to safeguarding shareholder interests, dividend policy and risk management play
a crucial role. Dividend policy refers to the decision-making process that companies use to
determine how much of their earnings to distribute to shareholders in the form of dividends. Risk
management, on the other hand, is the process of identifying, assessing, and controlling risks that
may impact a company's financial performance and reputation. In this section, we'll explore
some best practices in dividend policy and risk management.

1. Consistency in Dividend Payouts:

One of the best practices in dividend policy is consistency. Consistent dividend payouts can help
build investor confidence and create a stable source of income for shareholders. Companies that
have a history of paying dividends regularly, even during tough economic times, are often
viewed favorably by investors. For example, the Coca-Cola Company has been paying dividends
for over 100 years and has consistently increased its dividend payout every year for the past 58
years.

2. Dividend Reinvestment plans:

Another best practice in dividend policy is to offer dividend reinvestment plans (DRIPs). DRIPs
allow shareholders to reinvest their dividends back into the company's stock, often at a
discounted price, which can help increase the company's ownership base. DRIPs can also help
reduce transaction costs for shareholders and provide a convenient way for them to reinvest their
dividends. For example, Procter & Gamble offers a DRIP program that allows shareholders to
reinvest their dividends in the company's stock.

3. Diversification of Revenue Streams:

Diversification of revenue streams is a best practice in risk management. Companies that rely on
a single product or service are at risk of losing revenue if that product or service becomes
obsolete or faces increased competition. Diversification can help mitigate this risk by spreading

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revenue across multiple products or services. For example, Amazon started as an online
bookseller but has since diversified into several other areas, including cloud computing and
streaming services.

4. Robust Internal Controls:

Robust internal controls are essential for effective risk management. Internal controls are policies
and procedures that help ensure that a company's operations are conducted in accordance with
established guidelines and laws. Effective internal controls can help prevent fraud, ensure
accurate financial reporting, and protect a company's reputation. For example, Wells Fargo's
recent scandal involving unauthorized customer accounts could have been prevented with
stronger internal controls.

5. Scenario Planning:

Scenario planning is another best practice in risk management. Scenario planning involves
developing and analyzing multiple scenarios that could impact a company's financial
performance. By considering a range of possible outcomes, companies can better prepare for
potential risks and develop contingency plans. For example, airlines often use scenario planning
to prepare for potential disruptions, such as weather events or labor strikes.

2.3 factors affecting the dividend policy

Dividend policy is a crucial aspect of any company's financial management. It refers to the
decision-making process that determines the amount and frequency of dividend payouts to
shareholders. Companies make these decisions based on various factors such as their financial
position, investment opportunities, and shareholder expectations. There are several factors that
companies must consider when crafting an optimal dividend payout ratio strategy. Each of these
factors plays a crucial role in determining the best approach for a particular company. In this
section, we will discuss these factors in detail.

One of the most critical issues that a company must decide on is its dividend policy. It is a
decision that affects the future of the company and its relationship with shareholders. A
company's dividend policy determines how much of its earnings to distribute to its shareholders
and how much to retain for reinvestment. With this in mind, a company needs to consider
various factors that could affect its dividend policy decisions. These factors can be categorized
into two types: internal and external. Internal factors are those that relate to the company's
financial position and its operations, while external factors are those that relate to the external
environment in which the company operates.

1. Company goals and objectives:

One of the most important factors that companies must consider when formulating a dividend
policy is their goals and objectives. Companies must determine whether they aim to maximize
shareholder value or reinvest profits to fuel growth. If a company's goal is to maximize
shareholder value, it may opt for a higher dividend payout ratio to attract investors. On the other

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hand, if a company aims to reinvest profits to fuel growth, it may choose to retain earnings and
reinvest them in the business.

2. Financial position:
A company's financial position is another crucial factor that determines its dividend policy.
Companies with a strong financial position may opt for a higher dividend payout ratio, while
those with weaker financials may choose to retain earnings for future growth. For instance, if a
company has a significant amount of cash reserves, it may opt for a higher dividend payout ratio
to reduce its cash balance.

3. Industry standards:
Industry standards also play a role in determining a company's dividend policy. Companies in
mature industries with stable cash flows tend to have higher dividend payout ratios. In contrast,
companies in growth industries with uncertain cash flows may have lower dividend payout
ratios. For instance, technology companies often have lower dividend payout ratios as they
reinvest profits to fuel future growth.

4. Tax implications:
Tax implications can also influence a company's dividend policy. In some cases, companies may
opt for share buybacks instead of higher dividend payouts to avoid tax liabilities. Share buybacks
can help increase shareholder value without incurring tax liabilities.
Crafting an optimal dividend payout ratio strategy requires careful consideration of various
factors. While there is no one-size-fits-all approach, companies must determine their goals and
objectives, financial position, industry standards, and tax implications to make informed
decisions. By considering these factors, companies can develop a dividend policy that aligns
with their long-term goals and objectives.

5. Profitability:
One of the most crucial internal factors that affect a company's dividend policy is its
profitability. A company cannot pay dividends if it does not have profits. A company must
generate sufficient earnings to pay dividends to its shareholders. A company that has a high-
profit margin can pay a high dividend to its shareholders.

6. Investment Opportunities:
The availability of investment opportunities is another critical internal factor that can affect a
company's dividend policy. If a company has many investment opportunities that can generate
higher returns than the dividend, it may retain earnings and reinvest them in the business. In
contrast, if a company does not have many investment opportunities, it may pay higher dividends
to its shareholders.

7. Industry Norms:
External factors that can affect a company's dividend policy include industry norms. The
dividend payout ratio varies among industries. For example, utility companies generally have a
high payout ratio, while technology companies have a low payout ratio. A company needs to
consider the norms of its industry when deciding on its dividend policy.

8. Economic Conditions: The external environment also plays an essential role in a company's
dividend policy decisions. Economic conditions such as inflation, interest rates, and recession

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can affect a company's dividend policy. For example, during an economic recession, a company
may reduce its dividend payments to conserve cash.

2.4 other factors related to cash dividend

2.4.1 Stock dividend and stock split
Generally, the dividend is provided by the company to its shareholders in two ways, either in
cash or in additional stock. Stock dividend is a distribution of additional shares of a
company’s stock to existing shareholders whereas a stock split is done to divide the existing
shares into multiple shares. Stock Dividend and Stock Split may sound similar but have
completely different meanings.

2.1.4.1. What is Stock Dividend?

A stock dividend is a distribution of additional shares of a company’s stock to existing
shareholders. It is usually declared by the company’s board of directors and is paid out
to shareholders in the form of additional shares, rather than cash. The number of shares
received by each shareholder is typically proportional to their existing ownership
percentage in the company. For example, if a shareholder owns 100 shares and the
company declares a 10% stock dividend, the shareholder would receive an additional 10
shares.

2.4.1.2. What is Stock Split?

A stock split is a corporate action in which a company increases the number of
outstanding shares by dividing its existing shares into multiple shares. The purpose of a
stock split is to make the shares more affordable and increase their liquidity. The split is
usually expressed as a ratio, such as 2-for-1 or 3-for-1, which means that each existing
share is divided into two or three new shares, respectively. For example, if a company
declares a 2-for-1 stock split, a shareholder owning 100 shares would receive an
additional 100 shares but each share would be valued at half the amount of the original
i.e. after the split, the two shares would be worth the same as one share the shareholder
has started with.
Differences between Stock Dividend and Stock Split:
Stock Stock
Basis
Dividend Split
Distribution of additional shares to Division of existing shares into
Definition
existing shareholders. multiple shares.
Provide additional shares to Increase affordability and
Purpose
shareholders. liquidity of shares.

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 Stock Stock
Basis
Dividend Split
Nature of Share Issued Issued as a dividend. Splitting existing shares.
Can be declared at any time, including Often announced along with
Timing
outside of earnings season. earnings releases.
No impact on retained
Transfers from retained earnings to
Accounting Treatment earnings; par value per share
additional paid-in capital.
may change.
Generally considered taxable as Generally not considered
Tax Treatment
ordinary income. taxable at the time of the split.

2.4.2 Stock repurchases

What Is a Share Repurchase?

A share repurchase is a transaction whereby a company buys back its own shares from the
marketplace. A company might buy back its shares because management considers them
undervalued. The company buys shares directly from the market or offers its shareholders the
option of tendering their shares directly to the company at a fixed price.

Repurchases reduce the number of outstanding shares, which is something that investors
often feel will drive up share prices. This assumes demand for the shares will not be
diminished by the action.

How Share Repurchases Work?

Share repurchases take place when companies decide to buy back their stock. Companies that
repurchase their stock from the open market or directly from investors. Also known as a
share buyback, it is commonly done to achieve:

1 .An increase in equity value

2. A boost in the company's financial position
3. Consolidation
Because a share repurchase reduces the number of shares outstanding, it increases earnings
per share (EPS). A higher EPS elevates the market value of the remaining shares. After
repurchase, the shares are canceled or held as treasury shares, so they are no longer held
publicly and are not outstanding.

A share repurchase impacts a company's financial statements in various ways. A share

repurchase reduces a company's available cash, which is then reflected on the balance sheet
as a reduction by the amount the company spent on the buyback.

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 At the same time, the share repurchase reduces shareholders' equity by the same amount on
the liabilities side of the balance sheet. Investors interested in finding out how much a
company has spent on share repurchases can find the information in their quarterly earnings
reports.

Reasons for Share Repurchases

A share repurchase reduces the total assets of the business so that its return on assets, return
on equity, and other metrics improve when compared to not repurchasing shares. Reducing
the number of shares means earnings per share (EPS) can grow more quickly as revenue and
cash flow increase.

If the business pays out the same amount of total money to shareholders annually in
dividends and the total number of shares decreases, each shareholder receives a larger annual
dividend. If the corporation grows its earnings and its total dividend payout, decreasing the
total number of shares further increases the dividend growth. Shareholders expect a
corporation paying regular dividends to continue doing so.

In some cases, a buyback can hide a slightly declining net income. If the share repurchase
reduces the shares outstanding to a greater extent than the fall in net income, the EPS will
rise irrespective of the financial state of the business.

Is there a Tax on Stock BuyBacks?

The Inflation Reduction Act (IRA) of 2022 introduced a 1% excise tax on share repurchases
of over $1 million, of any US corporation trading on an established exchange. The tax
applies if more than $1 million of stock is purchased over the course of the tax year.

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